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Deputy Chief Accountant Discusses Challenges of Principles-Based Accounting

Deputy Chief Accountant James L. Kroeker discussed the challenges of implementing principles-based accounting at a recent conference in New York. Mr. Kroeker said he does not necessarily agree that U.S. accounting standards lack underlying objectives or principles. The problem is that numerous exceptions, bright-lines and voluminous implementation guidance can obscure the objective underlying the standard, in his view. One of the biggest challenges is defining what a principles-based standard should look like, he said.

Mr. Kroeker used the example of FAS No. 133 relating to derivatives and hedging transactions. At its core, Mr. Kroeker said the standard is based upon sound principles whose objectives are laid out in a few paragraphs. The standard is accompanied by over 800 pages of implementation-type guidance, he said, which is filled with scope exceptions, bright lines and rules. The sheer volume of the guidance is what makes it more difficult to apply the standard, in his opinion.

Mr. Kroeker said that comparability under a rules-based system can be an illusion. He explained that similar transactions can be structured to fall on either side of a bright line and then receive very different accounting treatments. Objectives-based standards, as outlined in the SEC's 2003 staff report, should help to achieve comparability based on economics rather than illusory comparability, he said. Principles-based standards should reflect the economic substance of transactions and events, according to Mr. Kroeker, and the objectives should frame the economic substance.

An overly proscriptive or rules-based regime may create an environment in which it is deemed acceptable for the terms of a transaction to be structured to achieve a specific accounting objective without consideration of the economics of the transaction, Mr. Kroeker said. However, he is uncertain whether there is a common understanding of what is meant by principles-based standards. A certain amount of implementation guidance may be needed to assist with the consistency of application, Mr. Kroeker noted. The hard part is determining how much and what type of implementation guidance is appropriate.

Mr. Kroeker explained that, to accommodate all of the requests for more guidance can lead back to rules-based standards and illusory effects on comparability, but to accommodate none of the requests may leave the impression that "anything goes,"and also lead to a lack of comparability. Any implementation guidance must be consistent with the objective of the standard, he said. Bright lines and rules may lead accountants to focus solely on the guidance while losing sight of the objectives or principles.

Mr. Kroeker added that any implementation guidance that is included within the standard should carry the same authority as the objective or any other guidance within the standard. When questions have to be answered by additional accounting literature, it adds to the complexity, he said. Mr. Kroeker suggested that standard setters carefully consider whether implementation guidance is even necessary.

Mr. Kroeker called for accounting professionals to refocus on the application of judgment with respect to the principles or objectives, rather than specific rules. Principles-based standards have the potential to increase the transparency and comparability of financial reporting, he said. A transaction for which significant judgment is required provides an opportunity for management to describe the economics, business purpose and the judgments on which the accounting conclusion was reached, according to Mr. Kroeker.

Mr. Kroeker described an example that has come to the staff's attention where certain parties have identified an "opportunity" in a series of transactions with respect to FASB's recently released fair value option standard. The opportunity appears to be intended to confuse investors rather than provide more meaningful information, he said. This activity does not promote the objective of the accounting standard, Mr. Kroeker said, and the SEC will take an interest in this approach.

Mr. Kroeker assured that the SEC is willing to accept reasonable views and interpretations in the application of accounting principles. However, there are best practices that preparers and auditors can use to minimize second-guessing. Mr. Kroeker urged management and auditors to make appropriate judgments based on the facts and circumstances, and to document the basis for the decision and any alternative approaches that were considered. The demonstration of reasonable, good faith judgments along with appropriate documentation may distinguish the bad actors from the rest, he said.

Nearly everyone agrees that something must be done about the complexity of the accounting standards, Mr. Kroeker said. The Office of the Chief Accountant staff is considering a framework for this effort, he advised.